Tuesday, October 6, 2009


Scott Sumner's Mind Is a Terrible Thing to Waste

Milton Friedman gave us many gifts, but among his undesirable ones was income tax withholding. He also gave an erroneous explanation of the Great Depression, namely that the timid Fed didn't pump in enough monetary base to prevent disaster. In addition to giving Bernanke the intellectual justification to destroy the dollar, Friedman's theory has body-snatched Scott Sumner.

Scott is one of my favorite bloggers, and yet I fear his one main idea--the thing everybody knows him for--is terribly mistaken. If and when the dollar collapses, Scott will be too intellectually honest just to shrug it off, blame deregulation and greedy speculators, and move on. No, Scott will probably abandon economics entirely, and finish his days preparing pounds of Beef & Broccoli in a Chinese restaurant down the street from GMU. (I shudder to think of it.)

For a great example of the terrible waste of a perfectly good economics blogger, consider Scott's most recent post, "We don't expect inflation, but we expect to expect it soon." Now anyone who has been through a grad program in economics can remember the fun with nested expectation operators! Ah, good times, good times. But rather than reminisce, let's get down to business.

Scott is upset that the "market's expectation" of inflation--whether gauged by CPI futures or TIPS/nominal bond spreads--is less than 2%, while the ostensible Fed target for inflation is 2%. So what gives? Scott suggests:
It seems to me that the Fed is for some strange reason assuming that there is a logical distinction between inflation expectations and expectations of inflation expectations. In other words, they see that inflation expectations aren’t a problem right now, but they expect them to be a problem in the near future unless they tamp them down with some hawkish talk. But that commits a fundamental logical error; the Fed is ignoring the fact that those inflation expectations (both market and private forecasters) are formed with knowledge of current and expected future Fed policy, including the 0.25% target rate and the massively bloated monetary base that everyone seems worried about.

I think Scott is overlooking a pretty obvious point here. What if the market is forecasting low inflation because Fed officials are assuring them that they will suck out all that extra liquidity when the time is right?

Imagine Scott's in an airplane, coming back from a pleasant few days at GMU. He wanders into the cockpit and asks the pilot why he doesn't take a nap. "Well, if I took a nap, the plane would eventually crash and we'd all die."

"You really think so?" challenges Scott. "Give me the mic. 'Attention everyone! I'm conducting a survey. How many people aboard the plane think we are all going to die within the next hour? Show of hands? OK, just one of you, the guy with the Ron Paul shirt in the seat 13A, who's been talking about a green monster on the wing for the last hour. OK thanks everyone.'"

Scott puts the mic back. "See, Mr. Pilot? You're worried about nothing. Everyone has confidence that we won't crash. Go ahead and catch a few winks."

OK let's move on to another gem in Scott's analysis:
Here’s what the Fed doesn’t seem to realize. If the market thinks inflation will be too low under current and expected future Fed policy, then the Fed needs to send out more dovish signals not hawkish signals. They need to get 2-year inflation expectations up to around 2% or 3%. And that would require a much more expansionary monetary policy. Yes that’s right, I’m suggesting we go back to how things used to be in 1958 and 1983, when very steep recessions were followed by very rapid recoveries. Why not? Instead, everyone is estimating really high unemployment for years to come. Correct me if I am wrong, but I don’t recall the 1958 and 1983 recoveries leading to double digit inflation. Sure we’ve got some structural problems, but in 1983 we were in the midst of a painful downsizing of the so-called rustbelt’s manufacturing capacity as a result of technology and foreign competition. That was a huge structural problem, similar to our overbuilt housing stock. Indeed, because of population growth the housing overhang may be solved more quickly than that earlier structural adjustment. And yet RGDP grew very fast in 1983-84.

Hmm let's go to the tape:

So Scott looks at that chart and says: "The reason we had a rapid recoveries in 1958 and 1983, while we have a sluggish recovery right now, is that the Fed obviously hasn't pumped in enough monetary stimulus this time around. And for those critics who think we are risking (price) inflation, all I have to ask is: Why weren't your fears borne out in 1958 or 1983? Morons."

Shall I stoop to another analogy? Sure why not; it's the Internet:

Scott's buddy has the flu. Scott starts subjecting the guy to massive doses of radiation. "Whoa whoa whoa, what are you doing?!" Gary North says.

"I'm helping him get better!" Scott explains. "Many doctors think radiation is a good way to make people well."

"Any doctor who tells you radiation fixes the flu is an idiot," North declares. "You're going to kill him if you keep that up!"

"Oh please!" Scott rolls his eyes. "My cousin and my brother-in-law both had really bad cases of the flu when they were growing up, and correct me if I'm wrong, but they didn't die of radiation poisoning. Jeez. OK sir, for some inexplicable reason, the radiation therapy isn't taking. I'm gonna put your head into my microwave for 30 seconds. Ready? I want to make sure you expect what I'm about to do to you."

Last few points for Scott, in case he reads this:

(1) If the whole justification for money-pumping is nominal price rigidities, shouldn't those fade away after a year or two? In other words, how can you warn us about a decade of Japanese stagnation, if the ultimate cause is that it takes nominal prices a while to adjust downward? It really takes ten years for people to stop resisting a wage cut?

(2) If the Fed is so tight, and the market is expecting (price) deflation / stagnation, why has gold risen about 19% year-to-date? Again I ask, are bond traders smart but commodity traders stupid? Is it possible that the ginormous central bank purchases of debt instruments has something to do with it?

(3) In the late 1990s there was a bubble in Internet stocks, and as time passed more and more people knew it. A few years later there was a bubble in real estate, and as time passed more and more people knew it. Weren't those cases where people "expected prices to rise, but expected to expect them to fall"? If we've had two huge bubbles in the last 10 years, why is it so inconceivable that there is a bubble right now in US Treasurys?

ROFL! at the airplane analogy :-)
This was the greatest post ever. Both the airplane and the flu analogy were top class. Not to mention the nested expectations operators!

I don't I've ever laughed so hard for an economics blog.
Dr. Murphy,

Like Silas, I thought the airplane analogy was simply hilarious, all the more so because it was apt.
The sticky wage point is a good one, it cannot explain ten years worth of recession, and I don't expect that. I do think it will be unnecessarily long, however. I don't buy the pilot example. People would forecast a crash if they were asked to make a conditional forecast assuming the pilot slept. And I don't doubt that people would expect too much inflation if asked to make a forecast conditional on the Fed keeping the base at its bloated levels, and ending its interest on reserves program.
BTW, pilots can steer a plane more effectively than passangers. But Fed officials can't steer the economy better than the markets. That's my point, and it's a very Austrian point.
Good post. Cracked me up and made several good points. Nested expectations operators reminds me of Vizzini from Princess Bride:

"Vizzini: But it's so simple. All I have to do is divine from what I know of you: are you the sort of man who would put the poison into his own goblet or his enemy's? Now, a clever man would put the poison into his own goblet, because he would know that only a great fool would reach for what he was given. I am not a great fool, so I can clearly not choose the wine in front of you. But you must have known I was not a great fool, you would have counted on it, so I can clearly not choose the wine in front of me."
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